Thursday, 12 January 2017

Kocherlakota’s argument for fiscal expansion in the US

Is
there a macroeconomic case for tax cuts in the United States right
now? Paul
Krugman and I
say no, using
the following logic. The Fed thinks we are close to full employment,
if we use the term to denote the level of employment that keeps
inflation constant. Generalised tax cuts (rather than just tax cuts
to the very rich) will tend to raise aggregate demand, which will
lead inflation to increase. The Fed will therefore raise interest
raise rates further to offset this increase in demand before it
happens. As a result, the tax cuts will have no impact on demand, but
simply make funding investment more expense.

There
are clear grounds for saying that the Fed is wrong about the economy
being close to full employment, and therefore any increase in
aggregate demand from any source would not raise inflation. But a
central bank that acts in the textbook manner will not wait for the
higher inflation to materialise, but will anticipate it because it
takes time for interest rates to influence demand and inflation. As a
result, tax cuts will lead to higher interest rates and there will be
no net impact on demand.

Narayana Kocherlakota, who used to
be on the committee that sets US interest rates, presents
another possible reason why an increase in demand will not raise
inflation. He argues that aggregate supply has been suppressed by low
demand, and that rising demand might itself stimulate supply. For
example, a lot of technical innovations might have been shelved while
demand was depressed, but would be brought into production if demand
looked like expanding rapidly. As these technical innovations would
expand the capacity of firms to produce more, they would not raise
prices as a result of any increase in demand. As these innovations
would produce more from the existing labour force, there would be no
inflation pressure coming from wages either.

If this sounds like wishful
thinking, remember than the US economy, like most, is still way below
the level of output that pre-recession trends would have suggested
were likely. Did research into new and better production techniques
really slow down substantially during the recession years, or did the
research still take place to be implemented at some later date?

Even if this argument is plausible,
and I think it is, it would still be irrelevant if the Fed didn’t
make any allowance for it. They would still believe that tax cuts
would raise demand and inflation, and so they would raise interest
rates and crowd out any increase in demand. Indeed, if the Fed
believed this ‘endogenous supply’ argument, they surely wouldn’t
have raised rates in 2016.

What Kocherlakota wants the Fed to
do is follow an approach put forward
by Federal Reserve Bank of Chicago President Charles Evans. He puts
the case in this speech.
Essentially the Fed should depart from the usual policy approach of
targeting expected inflation, and wait for inflation to actually rise
above target before it raises rates. This would mean that it ignored
any fiscal stimulus (whether it be tax cuts or additional public
investment), and focused simply on the actual inflation rate. If we
were in fact below full employment, or if demand created its own
supply, the fiscal expansion would raise output and welfare.

An important point that
Kocherlakota makes, and I have made in the past, is that you do not
need to believe with certainty that we are below full employment or
that demand will create its own supply. All you have to do is give it
some significant probability of being true. You then look at the
costs and benefits of pursuing an Evans type monetary policy weighted
by this probability. A key point here is that the costs of a short
term overshoot of the 2% target are likely to be a lot smaller than
the cost of missing out on a percent or two of national output for
potentially some time.

Does this change my views on a
prospective Trump stimulus package? Not really. There is a very
strong case for more public sector investment on numerous grounds.
But that investment should go to where it is most needed and where it
will be of most social benefit, and I think it is very unlikely (along with I suspect most economists) that a Trump
Presidency and a Republican House can deliver that. That extra public
investment will give the economy the stimulus that could work with an
Evans type monetary policy. From a macroeconomic viewpoint there
seems no point in doubling up on stimulus through tax cuts, and in
terms of how the Fed reacts it may even be counterproductive.

5 comments:

In support of SW-L’s thesis above, it could be argued that the tax cuts are going to the well off, who tend not to increase their weekly spending when their after tax incomes rises. Ergo interest rate hikes are not needed.

In contrast, and against the above thesis, I’m not sure about SW-L’s claim that “the costs of a short term overshoot of the 2% target are likely to be a lot smaller than the cost of missing out on a percent or two of national output for potentially some time.”

Obviously if the “overshoot” really is “short term”, then SW-L is right. However, the 1980s showed that the costs of weeding excess inflation out of the system can be long and painful.

The notion that the Fed (or anyone else) needs to act on what's going to happen is silliness. Nobody knows what's going to happen. Simply look at the Fed's own predictions of the future and it's clear that it has little clue. Also, the assumption that monetary policy works as predicted is without merit. The Fed lowered interest rates to zero to raise inflation. Did it? No. At some point, reality on the ground trumps theories. Perhaps the Fed should set the rate at zero and leave the rest to Congress.

" Also, the assumption that monetary policy works as predicted is without merit.""Thus instead of the central banking narrative that lower rates lead to higher growth, the empirical and verifiable reality is that higher growth leads to higher rates and lower growth leads to lower rates. If rates are the result of growth, they cannot be the cause."https://professorwerner.org/shifting-from-central-planning-to-a-decentralised-economy-do-we-need-central-banks/

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